Debt loads could lead to second recession: report

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By:Sunny FreemanThe Canadian Press Published on

TORONTO - There is more than a 20 per cent risk of Canada falling into a second recession — and though much of that risk comes from outside our borders, Canadians' sky high debt loads could push the economy over the edge, warns a new report from Moody's Analytics.

With debt-to-income ratios at an all-time high around 150 per cent, Canadians have stretched themselves to the limit since the recession and have left little head room to buffer against another economic downturn, Moody's suggests in the report released Thursday.

"With the economy now relying heavily on the continued expansion of household spending, any retrenchment in the consumer sector will likely place the economy on the brink of a second recession," the report's authors say.

The study — "Storm Clouds Gather Around Canadian Consumer Credit" — says while Canada has managed to outperform other G7 countries since the recession it has been propped up by consumer spending, while exports continue to lag.

Statistics Canada reported last week that the economy grew at an annual rate of 1.8 per cent in the second quarter. That beat analyst expectations, but it was the third quarter in a row for sluggish performance below two per cent.

And there is potential for exports to further weaken, given the very real possibility that Europe's debt crisis could deepen and spill over to other countries, and the fiscal crisis that Canada's largest trading partner, the U.S., is also facing.

"The situation that Canada faces is much riskier than in 2007-2008 when the first global financial crisis occurred," said Mark Hopkins, a senior economist at Moody's Analytics and one of the authors of the report.

With Canadians so deep in debt, it would be extremely difficult for domestic spending to pick up slack in the economy if things started to go downhill. That could result in a serious downward spiral in employment levels, household spending and the quantity and quality of credit outstanding, the report says.

"There's a legitimate fear that there may be a Wile E. Coyote moment here," says Hopkins.

"Households are spending money they assumed would be coming, then they realize they've run over the cliff because income from exports from these trading partners is not materializing and that's translating to weaker jobs."

The situation Canada currently faces is unique, the authors say, because domestic consumption is usually the more steady contributor to economic growth compared to exports and investment. But this time, household debt is out of control.

"Right now it all depends on the household sector and the household sector is overstretched, especially compared to historical trends," Hopkins says.

Slowing income growth, coupled with a coming rise in interest rates — which Moody's expects before the end of 2013 — will put more pressure on Canadian households and debt service costs will start to eat up a bigger portion of their take home pay, the report says.

In fact, Canadians, driven by ultra-low borrowing costs, have racked up so much debt since the recession that Canada's debt-to-income ratio is now higher than what the U.S. faced just prior to its mortgage crisis that sparked the so-called "Great Recession."

However, recent moves by the government to tighten lending rules, as well as an ingrained culture of conservative lending standards, positions Canada to better withstand a downturn than consumers in the U.S. prior to 2008.

"There certainly are risks though they're not as catastrophic as they were in the U.S.," says Cristian de Ritis, a director at Moody's Analytics who co-authored the report.

Canadians household debt levels continue to reach new highs each quarter, according to Equifax Canada, which provided data for the report.

And while some point out that Canadians delinquency and default rates are very low, the Moody's analysts say this is often the case in a credit boom — the "calm before the storm" — because the availability of cheap credit allows people to keep borrowing and gives more flexibility in paying it back.

The problem is once a crisis hits, which most likely would be caused by external factors, it could be exacerbated because so many Canadians have little wiggle room to borrow and spend. Defaults and delinquencies could rise quickly and leave more households underwater, they say.

Hopkins puts the chances of a second Canadian recession at one-in-five, while de Ritis is slightly gloomier and puts the odds at one-in-four.